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Mutual Funds 101

Last week we covered the basics of bonds, this week we’re diving into a different popular security, mutual funds. There is an enormous variety of mutual funds, so no matter what your investing style is, you can find a mutual fund to match it. They can also be a great choice for investors with limited capital.

If you’re not clear on how mutual funds work or what benefits they offer, keep reading.

What exactly is a mutual fund?

A mutual fund is an investment instrument comprising multiple investments (stocks, bonds, or other assets) that have all been pooled together. This means that buying a single mutual fund share is actually buying you a tiny slice of many investments. When you buy into a mutual fund, you are actually increasing the fund’s net assets, i.e., the size of the fund, as opposed to trading a finite number of shares. A mutual fund is considered an equity security (like stocks), because mutual fund shares represent an ownership stake in the whole fund.

For an investor with limited investable capital, a few well-selected mutual funds can provide instant portfolio diversification, meaning you don’t have to spread your capital thinly across many stocks to achieve diversification.

The performance of the fund is largely based on the collective performance of the assets within that mutual fund. However, as mentioned above, the more investors that buy into a fund, the larger the fund grows, which can affect the way it is managed. More on this later.

Who decides on the investments in a mutual fund?

Mutual funds are managed by fund managers, who make the investing decisions about how the fund’s capital is allocated. Each fund has a prospectus that lays out the structure and objectives for the fund—fund managers must adhere to the prospectus.

What types of mutual funds are there?

Similar to ETFs (exchange-traded funds), there is an unimaginably large population of different types of mutual funds. There are three major types:

Do mutual funds tell you what securities make up the fund?

Yes, within 60 days after a quarter closes, they must publish their holdings at the close of business day on the last day of the prior quarter. Most funds do it within 30 days. Some funds also publish their top 10 holdings and their percentage weightings in the portfolio every month with a 10- or 15-day lag.

How are mutual funds traded?

Unlike stocks and ETFs, mutual funds trade only once per day, after the markets close at 4:00pm ET. If you enter a trade to buy or sell shares of a mutual fund, your trade will be executed at the next available net asset value, which is calculated after the market closes and typically posted by 6:00 pm ET.

Note that liquidity and volume, which are critical for evaluating stocks and ETFs, don’t really apply to mutual funds, because they don’t have volume per se. The actual transaction is either buying or redeeming shares directly with the mutual fund company. The level of mutual fund transaction data is not published by the companies.

What drives share value?

The simple answer is the performance of the weighted average of the underlying holdings. However, there are additional factors to consider.

If a fund has a certain investment style (e.g., small cap growth), does well, and attracts too many assets (i.e., too much investor capital), it may hinder the fund’s ability to productively invest in the area, as it will become too big an owner of the “best” assets (based on limits set in the fund’s prospectus). This generally means chasing additional assets that are not as good, which in turn makes performance suffer. Some funds close when they feel they are getting too big. Others don’t.

If a fund is suffering a lot of redemptions (i.e., investors selling their shares), it will keep a much higher cash balance than normal which may hurt performance (or help it in down markets).

Additionally, if the fund is large or operates in areas where trading volume is light, and it has to liquidate a lot of a particular security, that can depress the price of the security, sometimes significantly.

How can an investor analyze a mutual fund?

As with any investment, you want to make sure the mutual fund aligns with your goals as an investor and will bring the elements you are looking for to your portfolio.

To analyze a fund, you can start by looking at the management team and the lead manager. Assess the team’s background, how long they have been together, their track record (fund performance) in different kinds of markets and environments.

Then take a look at how the fund has performed against peers. Is there a better fund out there that does basically the same thing? If the fund tracks an index, look at how well it has done versus the index and with how much volatility.

Look at the fund’s prospectus. Take a look at the rules and limitations for sector and stock concentration. Understand the rules about whether it needs to be fully invested or if it can keep large sums in cash. A fund that can hold a lot of cash has the flexibility to try and time the market for better performance, but it could also underperform the market if it’s holding cash in good times. See also whether the fund can use leverage, which adds to the riskiness of the investment.

Look at what the fund holds, particularly its top holdings and how many positions it holds in total. How much do you like the top picks? How concentrated is the fund in its top holdings?

Then look at fees. First are there any load fees? That is one-time costs to get in or get out. There can also be penalties if you don’t hold the fund for at least 90 days. Next, what is the expense ratio? This is the management expense fees, plus the administrative cost of running the fund, plus trading costs and the 12B-1 fee, which is used to pay for advertising and promoting the fund. That’s right, if you invest in a fund with a 12B-1 fee, you are paying for the fund to run commercials and sell itself.

Where can one find all this information?

In Stock Rover, you can type the name of a mutual fund into the Quotes Box, just as you would a stock, to get pricing and performance data. For many funds, you’ll be able to find additional data, such as net assets and the expense ratio, in the Insight panel (right side of the Stock Rover screen). If the particular mutual fund you are looking for is not found, you can add it to the database for pricing.

If you have linked your portfolio to your brokerage, mutual funds that you own will appear automatically in your portfolio. If you are manually updating your portfolios, you can add mutual funds in the same that you would add a stock in the Update Portfolio window.

Morningstar has excellent information on funds, including an analyst write-up on the fund for the paid version of Morningstar.

You can always find the details about a fund at its mutual fund company. For example, Fidelity funds can all be found on the Fidelity website.

How are mutual funds different from ETFs?

ETFs (exchange-traded funds) have some legal and structural differences with mutual funds, but they are functionally very similar, from an investor perspective. ETFs can be thought of as mutual funds with lower fees that do less active management.

They key difference is that ETFs trade like stocks during the day whereas mutual funds do not. So for ETFs, volume and liquidity are critical. As mentioned earlier, the concepts of volume and liquidity don’t apply to mutual funds because there is not a specific number of shares to be traded.

ETFs can also be more tax efficient. You only register a gain or loss when you sell the ETF shares. Mutual funds can sometimes take on big capital gains for stuff they owned a long time ago and sold in the current year—potentially stuff they had before you ever owned the fund. So you get stuck with the tax on the gains even though you didn’t actually experience the gains.

What about hedge funds? Are they similar?

No, mutual funds are not similar at all to hedge funds. First, hedge funds are not currently regulated by the SEC, while mutual funds are. Unlike mutual funds, hedge funds can own illiquid and not-publicly-priced assets, and they are not priced daily. Hedge funds often use leverage, which can make them very risky. Whereas mutual funds can be a great option for low net worth investors, hedge funds are only available to registered (accredited) investors who have liquid net worth above $1M.

There are lots of other differences—in manager compensation, redemption periods, and more—however, you probably get the idea. Mutual funds and hedge funds don’t have much in common other than the word “fund.”

Conclusion

We hope you found this to be a useful overview of mutual funds. As you can see, a mutual fund can be an effective addition to stocks and bonds to help you achieve balance and diversity in your portfolio.